I have been personally involved with several positions in U.S.-listed Chinese companies and have suffered quite badly from those positions. And recently the report published by Carlson Block targeted one of the biggest Canadian-listed Chinese companies in the forestry field — Sino-Forest (TRE). After the report was released, the stock, which opened at $18, immediately was brought to under $2.5. And one big hedge fund took a hit: Paulson and Co. of John Paulson, which had a holding of 34.7 million shares in Sino-Forest, might have encountered a loss of more than $500 million on that position.
Reverse Takeovers (RTO)
At the birth of Sino-Forest, like other Chinese companies operating in China, it was listed in Toronto Venture Exchange via reverse takeover (RTO). (Readers can read more about RTO in Reverse Mergers: A Short Guide for Chinese Firms to U.S. Investors). The company was formed in 1994, and its main business is claimed to include the ownership and management of tree plantations and manufacturing of downstream engineered-wood products. And it is said by Sino-Forest that the revenue mainly comes from the sales of wood fibre to produce industrial, commercial and residential wood products. In September 2009, Sino-Forest claims to have had approximately 757,000 hectares of trees under management and over 700,000 hectares of trees available to be acquired under its six long-term master agreements. The company intends to replant 200,000 hectares by 2012. It also said that the company is expected to benefit from China’s economic stimulus plan to increase infrastructure development, rebuilding after Sichuan’s 2008 earthquake and more building of housing for rural areas.
Authorized Intermediaries
It is reported that the foundation of Sino-Forest (TRE) fraud is on the company’s revenue via so-called “authorized intermediaries” (AI). AI is considered to be the customer who would have to pay much of TRE’s VAT (value-added taxes) and income taxes. Actually the structure of using AI that purportedly purchased from TRE without requiring the company to generate VAT invoices can allow TRE to paint more sales without being seen by the tax authorities.
We will see below that TRE treated AI as both customers and suppliers. The activity of AI would include purchasing the raw timber (logs), and then delivering it to the chipping facility. Then it would turn all logs into wood chips, delivering wood chips to end users and it is AI who is responsible for collecting payments from customers, and then pays a percentage of net profit to TRE. So basically, AI is the entity who does nearly everything. TRE only has to do two things: The first one is to reimburse the costs of AI, including the costs of purchasing raw material and pay processing fees and management fees. Nevertheless, all those fees would be deducted from the sales proceeds of wood chips. So basically, AI would be reimbursed right on the sales money of wood chips. And the second thing is TRE assumed “all risks and obligations relating to the raw timber once it arrives at the premises of the AI until it is processed into wood chips, except for any loss arising as a result of the AI’s default.”
Only one AI is revealed to the investors, named Lei Guangyu, who is also the president of Hongji Company, and it appears that both Lei Guangyu and Hongji are closely related to TRE with complicated and related transactions within arm's-length.
Manipulated Assets
Although TRE claimed that they have purchased up to nearly $2.9 billion in timber, the report of Carson Block stated the evidence taken in Yunna province: The purchase has been overstated by more than $800 million. Block's team has been able to identify five agents. Only one in Yunnan is legitimate, and the other agents have been moving large amounts of cash to an undisclosed subsidiary of TRE and the trading company that TRE is doing business with. It smells like laundering money for the rest of the TRE’s agents.
Jakko Poyry’s Valuation Report
Jakko Poyry was engaged by TRE to write all of the valuation reports. Poyry only are allowed to get access to only 0.3% of the total purported timber holdings, and due to the new plantation, Poyry has reported in the conference call in June 2011 that the ratio is only 0.1% for now. And in TRE’s annual meeting in May 2011, CFO David Horsley said that Poyry team has spent “six personal weeks” for valuation work in the field. However, on the telephone call with analysts one day later, Poyry clarified that four men spent only six days, not six weeks.
Dated back 2003, the purpose of Poyry is only to estimate the real market value of forest assets based on information provided by TRE, but would not perform any due diligence or confirm the forest areas ownership. In the valuation reports, Poyry has stated that it has not viewed any contracts or legal documents for forest land-use rights or forest asset purchase. It is not a confirmation of forest ownership.
Poyry has realized the unusual trading activities in TRE. “Unlike most forest owners and managers, Sino-Forest actively trades in forests. Each year the company both sells and buys forests, and accordingly the composition of the forest estate changes much more than for a business that is simply managing and harvesting a more static resource.” And on the valuation process: “the composition of Sino-Forest’s estate can change quite significantly from one year to the next.”
Complicated offshore structure
Like other RTO Chinese companies, TRE has a complicated offshore structure with cross holdings and many subsidiaries, and it confuses readers — those types of Chinese companies confuse me whenever I read the formation and the holdings of one another in their structure. For the date of this writing, I cannot get accessed to the annual information filing of 2010, only in 2009. In the AIF 2009, I manual count of around 39 entities in BVI, seven entities in Hong Kong, 35 entities in PRC, and one in Bermuda, where the majority of holdings into those entities are 100%, some at 99.99%, and only two entities that TRE holds minority interest.
Conclusion
Sino-Forest Corporation is a lesson in careful due diligence for nearly all investors. Investors should screen every single company with skeptical eyes. Whenever there are any signs of fraud, or things that investors cannot understand even reading back and forth through the annual report, as Warren Buffett relates to Enron annual reports that may be because the company does not want the readers to understand. Investors like us should be much better off to learn the lessons via the frauds in the financial history. As Charlie Munger put it: “All I want to know is where I'm going to die so I'll never go there.”Also check out:
Reverse Takeovers (RTO)
At the birth of Sino-Forest, like other Chinese companies operating in China, it was listed in Toronto Venture Exchange via reverse takeover (RTO). (Readers can read more about RTO in Reverse Mergers: A Short Guide for Chinese Firms to U.S. Investors). The company was formed in 1994, and its main business is claimed to include the ownership and management of tree plantations and manufacturing of downstream engineered-wood products. And it is said by Sino-Forest that the revenue mainly comes from the sales of wood fibre to produce industrial, commercial and residential wood products. In September 2009, Sino-Forest claims to have had approximately 757,000 hectares of trees under management and over 700,000 hectares of trees available to be acquired under its six long-term master agreements. The company intends to replant 200,000 hectares by 2012. It also said that the company is expected to benefit from China’s economic stimulus plan to increase infrastructure development, rebuilding after Sichuan’s 2008 earthquake and more building of housing for rural areas.
Authorized Intermediaries
It is reported that the foundation of Sino-Forest (TRE) fraud is on the company’s revenue via so-called “authorized intermediaries” (AI). AI is considered to be the customer who would have to pay much of TRE’s VAT (value-added taxes) and income taxes. Actually the structure of using AI that purportedly purchased from TRE without requiring the company to generate VAT invoices can allow TRE to paint more sales without being seen by the tax authorities.
We will see below that TRE treated AI as both customers and suppliers. The activity of AI would include purchasing the raw timber (logs), and then delivering it to the chipping facility. Then it would turn all logs into wood chips, delivering wood chips to end users and it is AI who is responsible for collecting payments from customers, and then pays a percentage of net profit to TRE. So basically, AI is the entity who does nearly everything. TRE only has to do two things: The first one is to reimburse the costs of AI, including the costs of purchasing raw material and pay processing fees and management fees. Nevertheless, all those fees would be deducted from the sales proceeds of wood chips. So basically, AI would be reimbursed right on the sales money of wood chips. And the second thing is TRE assumed “all risks and obligations relating to the raw timber once it arrives at the premises of the AI until it is processed into wood chips, except for any loss arising as a result of the AI’s default.”
Only one AI is revealed to the investors, named Lei Guangyu, who is also the president of Hongji Company, and it appears that both Lei Guangyu and Hongji are closely related to TRE with complicated and related transactions within arm's-length.
Manipulated Assets
Although TRE claimed that they have purchased up to nearly $2.9 billion in timber, the report of Carson Block stated the evidence taken in Yunna province: The purchase has been overstated by more than $800 million. Block's team has been able to identify five agents. Only one in Yunnan is legitimate, and the other agents have been moving large amounts of cash to an undisclosed subsidiary of TRE and the trading company that TRE is doing business with. It smells like laundering money for the rest of the TRE’s agents.
Jakko Poyry’s Valuation Report
Jakko Poyry was engaged by TRE to write all of the valuation reports. Poyry only are allowed to get access to only 0.3% of the total purported timber holdings, and due to the new plantation, Poyry has reported in the conference call in June 2011 that the ratio is only 0.1% for now. And in TRE’s annual meeting in May 2011, CFO David Horsley said that Poyry team has spent “six personal weeks” for valuation work in the field. However, on the telephone call with analysts one day later, Poyry clarified that four men spent only six days, not six weeks.
Dated back 2003, the purpose of Poyry is only to estimate the real market value of forest assets based on information provided by TRE, but would not perform any due diligence or confirm the forest areas ownership. In the valuation reports, Poyry has stated that it has not viewed any contracts or legal documents for forest land-use rights or forest asset purchase. It is not a confirmation of forest ownership.
Poyry has realized the unusual trading activities in TRE. “Unlike most forest owners and managers, Sino-Forest actively trades in forests. Each year the company both sells and buys forests, and accordingly the composition of the forest estate changes much more than for a business that is simply managing and harvesting a more static resource.” And on the valuation process: “the composition of Sino-Forest’s estate can change quite significantly from one year to the next.”
Complicated offshore structure
Like other RTO Chinese companies, TRE has a complicated offshore structure with cross holdings and many subsidiaries, and it confuses readers — those types of Chinese companies confuse me whenever I read the formation and the holdings of one another in their structure. For the date of this writing, I cannot get accessed to the annual information filing of 2010, only in 2009. In the AIF 2009, I manual count of around 39 entities in BVI, seven entities in Hong Kong, 35 entities in PRC, and one in Bermuda, where the majority of holdings into those entities are 100%, some at 99.99%, and only two entities that TRE holds minority interest.
Conclusion
Sino-Forest Corporation is a lesson in careful due diligence for nearly all investors. Investors should screen every single company with skeptical eyes. Whenever there are any signs of fraud, or things that investors cannot understand even reading back and forth through the annual report, as Warren Buffett relates to Enron annual reports that may be because the company does not want the readers to understand. Investors like us should be much better off to learn the lessons via the frauds in the financial history. As Charlie Munger put it: “All I want to know is where I'm going to die so I'll never go there.”Also check out: